Chapter 8 Firms in the Global Economy
Summary 1. Introduction International trade is an important economic activity 2. General equilibrium model There are welfare gains from trade whenever relative prices are different across countries 3. Classic Models Comparative advantages lead to differences in relative prices Ricardo: technological differences Specific Factors and HO: differences in relative factor endowments ECON 40710 University of Notre Dame 5-2
Overview 4. New Trade Theories Trade is mostly between similar countries Firms trade, not countries New motives for trade: returns to scale and product differentiation 5. Trade Policies The impact of trade policy depends on the size of the country and the structure of the industry ECON 40710 University of Notre Dame 5-3
INTRODUCTION ECON 40710 University of Notre Dame 5-4
Two waves of globalization ECON 40710 University of Notre Dame 5-5
First wave: composition ECON 40710 University of Notre Dame 5-6
Second wave: composition ECON 40710 University of Notre Dame 5-7
First vs. Second wave: destinations ECON 40710 University of Notre Dame 5-8
First wave of globalization Trade in dissimilar products between dissimilar countries Britain traded mostly with distant countries able to produce what it could not: Britain is densely populated and capital-abundant but scarce in land It exports manufactured goods and imports raw materials Comparative advantage theories explain those patterns ECON 40710 University of Notre Dame 5-9
Second wave of globalization Trade in similar product between similar countries Britain trades mostly with similar nearby European countries Trade is mostly manufactured goods Comparative advantage theories cannot explains this pattern We need to develop additional explanations for trade New Trade Theories Returns to scale and Product differentiation ECON 40710 University of Notre Dame 5-10
Road Map Intra-industry Trade Concept and measurement Monopolistic competition model (Krugman, 1980) New source of gains from trade: increases in varieties Heterogeneous firms model (Melitz, 2003) New source of gains from trade: increases in aggregate productivity Empirical Applications NAFTA ECON 40710 University of Notre Dame 5-11
INTRA-INDUSTRY TRADE ECON 40710 University of Notre Dame 5-12
Intra-Industry Trade In classic models of international trade: Countries are different (technology or resources) Trade leads to specialization according to comparative advantage Inter-industry trade: exchange of one product for another ECON 40710 University of Notre Dame 5-13
Intra-Industry Trade Intra-industry trade: Two-way exchanges within narrowly defined product categories exchange of one variety for another Suppose that the global cloth industry produces differentiated varieties or types of cloth. Each country produces and exports different types of cloth Firms exploit economies of scale through the lengthening of production runs specialize in a subset of varieties If different consumers like different varieties, trade occurs within the cloth industry ECON 40710 University of Notre Dame 5-14
Intra-Industry Trade Home produces and exports only cloth Foreign exports cloth and food, but is a net importer of cloth ECON 40710 University of Notre Dame 5-15
Intra-Industry Trade How important is intra-industry trade relative to inter-industry trade? We can use the Grubel-Lloyd index: Share of Intra Intra Total =1 EXP IMP EXP + IMP See notes ECON 40710 University of Notre Dame 5-16
Intra-Industry Trade Using that measure as much as 60% of world trade is classified as intra-industry trade. Lots of variation in intra-industry trade across countries across industries Classification issues: The amount of intra-industry trade depends on the level of aggregation The more aggregated the classification the more intra-industry trade ECON 40710 University of Notre Dame 5-17
Intra-Industry Trade Share of Intra-Industry Trade in manufacturing (1996-2000) Country Country Iceland 20.1 USA 68.5 Australia 29.8 Netherlands 68.9 Greece 36.9 Spain 71.2 Norway 37.1 Belgium 71.4 Turkey 40 Germany 72 New Zealand 40.6 Switzerland 72 Japan 47.6 Hungary 72.1 Finland 53.9 Mexico 73.4 Ireland 54.6 U.K. 73.7 Korea 57.5 Austria 74.2 Portugal 61.3 Slovak Rep. 76 Poland 62.6 Canada 76.2 Italy 64.7 Czech Rep. 77.4 Denmark 64.8 France 77.5 Source: OECD ECON 40710 University of Notre Dame 5-18
Intra-Industry Trade Intra-industry Trade in the US ECON 40710 University of Notre Dame 5-19
MONOPOLISTIC COMPETITION ECON 40710 University of Notre Dame 5-20
Monopolistic Competition We need models of trade consistent with intra-industry trade between similar countries. This requires changing some of the assumptions we used in the classical theories: 1. Differentiated Products instead of homogeneous Consumers can distinguish between varieties: Domestic and foreign varieties are not the same. If consumers love variety, they will import foreign products even if domestic firms produce varieties of the same product. ECON 40710 University of Notre Dame 5-21
Monopolistic Competition 2. Increasing returns to scale Fixed production costs: An increase in quantity leads to a decrease in average cost. Profits are increasing in total sales (conditional on price) Firms have an incentive to enter foreign markets to benefit from economies of scale. 3. Imperfect competition instead of perfect competition Small number firms Firms have some control over the price they charge Profits can be positive ECON 40710 University of Notre Dame 5-22
Monopolistic Competition Different types of imperfect competition: 1. Monopoly Single firm USPS is the only firm (ind. agency of the US gov.) allowed to deliver non-urgent letters in the US. 2. Duopoly Two firms Boeing and Airbus share the market for large aircrafts ECON 40710 University of Notre Dame 5-23
Monopolistic Competition 3. Oligopoly Small number of firms Soft drinks (World market share 2011: Coca-Cola 26%, Pepsi 12%, Nestle 3%, other 59%) Difficult to analyze because in general firms pricing decision are interdependent 4. Monopolistic Competition Assume away interdependence The number of firms is large enough that they ignore their impact on the market but small enough that they still have market power. ECON 40710 University of Notre Dame 5-24
Monopolistic Competition Is monopolistic competition realistic? Not entirely Firms are generally aware of their impact on the market Still useful because it captures important aspect of reality (e.g., price setting) and is simple to analyze Summary of key assumptions Each firm sells a different variety of the product Consumers like variety Firms take the prices of their rival as given The size (total expenditure) of the industry is fixed ECON 40710 University of Notre Dame 5-25
Monopolistic Competition P ECON 40710 University of Notre Dame 5-26
Monopolistic Competition A specific form for the demand function that satisfies those conditions is: " Q = S 1 # $ n % a(p P) & ' When P = P for all firms, Q = S/n When P < P, the firm s sales are above average a is a constant that governs the elasticity of demand how sensitive to prices consumers are. ECON 40710 University of Notre Dame 5-27
Monopolistic Competition Firms use a technology that includes both fixed and marginal production costs: TC = F + CQ F is a one time costs (e.g. building a plant) C is the (constant) marginal cost for each unit produced The average production cost (AC) is decreasing in output (increasing returns to scale) AC = F + CQ Q = F Q + C ECON 40710 University of Notre Dame 5-28
Monopolistic Competition Numerical Example Fixed costs F = $100 Marginal costs C = $10/unit Q VC = C x Q TC = F + C AC = TC/Q 10 $100 $200 $20 20 200 300 15 30 300 400 13.3 40 400 500 12.5 50 500 600 12 100 1,000 1100 11 1,000 10,000 10,100 10.1 ECON 40710 University of Notre Dame 5-29
Monopolistic Competition The MC is constant As Q increases the AC decreases When Q is very large, AC MC ECON 40710 University of Notre Dame 5-30
Monopolistic Competition In this model, firms are symmetric Same cost structure Same demand Therefore, in equilibrium all firms behave in the same way, i.e., there is a representative firm To describe the equilibrium, we only need to solve for: The behavior (price/quantity) of the representative firm The number of representative firms such that profits are zero (free entry equilibrium) ECON 40710 University of Notre Dame 5-31
Monopolistic Competition P P n ECON 40710 University of Notre Dame 5-32
Monopolistic Competition What is the impact of free trade? From the point of view of firms, free trade is equivalent to an increase in market size ( S). A higher demand allows firms to produce more output and better exploit economies of scale Trade allows countries to specialize in a narrower range of products Consumer can buy more varieties, which increase in welfare ECON 40710 University of Notre Dame 5-33
Monopolistic Competition An increase in S shifts AC down If the number of firms remains the same (n 1 ), profit are positive à Entry. A C Therefore n goes up and P goes down. B Note: n 1 is the number of domestic firms in closed econ. equil. n 2 is the sum of domestic and foreign firms in open econ. equil. ECON 40710 University of Notre Dame 5-34
Monopolistic Competition The total number of firms in the world under free trade is greater than the number of firms in one country under autarky. However, the number of firms in each country is lower under free trade than under autarky. Example: Suppose that both country are identical Find the total number of firms under free trade as a function of the number of firms in one country under autarky Find the number of firms in each country as a function of the number of firms in one country under autarky ECON 40710 University of Notre Dame 5-35
Monopolistic Competition Summary The model of monopolistic competition shows trade will occur between identical countries because of returns to scale and taste for variety. International trade: Forces some firms to exit the industry Increases the output of surviving firms P is lower so demand is higher S (in each country) is the same and n goes down ECON 40710 University of Notre Dame 5-36
Monopolistic Competition In equilibrium, consumers are better off for two reasons: They pay lower prices They can purchase more varieties (new source of GFT) ECON 40710 University of Notre Dame 5-37
CONCLUSIONS ECON 40710 University of Notre Dame 5-38
Conclusions Intra-industry Trade A large fraction of trade is between similar countries A large fraction of trade is in differentiated goods (manufactures) Monopolistic Competition Model Returns to scale and love of variety provides a new motive for trade Trade liberalization increases the number of varieties available for consumption New sources of GFT: An increase in the number of varieties available raises welfare ECON 40710 University of Notre Dame 5-39